Believe those who are seeking the truth. Doubt those who find it.Andre Gide

Wednesday, December 31, 2014

Brad DeLong on the Employment-to-Population Rate

Brad DeLong offers his musing here on the U.S. employment-to-population rate. As a rough control for demographic factors, he focuses on prime-age workers--those aged between 25-54. And he decomposes prime-age workers by sex. I like this exercise. In fact I've looked at the same data in an earlier post here, making comparisons with Canada.

DeLong normalizes the E-P rate for males and females to zero in the year 2000. For both sexes, the E-P rate is roughly 5% lower than in 2000. Here is his graph:

In reference to this data, DeLong asks a few questions. Heck, it's the end of the year and I'm in the mood to answer some of them.

(1) If the US economy were operating at its productive potential, the share of 25 to 54-year-olds who are employed ought to be what it was at the start of 2000. Back then there were few visible pressures leading to rising inflation in the economy.Does anybody disagree with that?

I'm not sure, so I think I'll disagree. It's very hard, I think, to know precisely what constitutes "productive potential." And the use of the word "potential" leads us (possibly incorrectly) to interpret the deviations in the graph above as "cyclical" (mean-reverting) fluctuations. I think that some of the decline in the male E-P rate can be reasonably thought of as being "below potential." I base my assessment on this graph (which I plotted a year ago and uses the 16+ population as a base):

This longer time-series shows a modest secular decline in the E-P ratio in both the U.S. and Canada since 1976. Personally, I think it's unlikely that the local peak in 2000 represents some magical measure of "potential." My hunch is that there are "structural" factors at play here including, but not limited to, things like rising disability rates. Having said this, I also don't believe that the male E-P rate has fully recovered. As I've mentioned before, the current dynamic resembles very much what Canada went through in the 1990s, i.e.,

The idea that the female E-P ratio is far below "potential" is even more misleading, I think. There's something strange going on with U.S. female employment relative to other advanced countries (all which resemble Canada in the diagram below).

Again, it's likely that a part of the post-2008 decline is cyclical. But its even more likely that most of the decline is structural (e.g., changing maternity leave benefits, etc.). My own feeling is that structural issues are better tackled through fiscal (or labor market) policies--not monetary policy.

(3) Even if you think–in spite of the absence of accelerating inflation–that employment in 2000 was above the economy’s long-term sustainable potential, there is no reason to believe that a U.S. economy firing on all cylinders would not have 25-54 employment to population rates–both male and female–back at their 2006 levels, a full 3%-age points–and 4%, 1/25–higher than today.Does anybody disagree with that?

I'm not going to disagree with this.

(4) The U.S. economy’s convergence towards its potential is very slow: The 25-54 employment-to-population ratio has only risen by 1%-point over the past two years.Does anybody disagree with that?

I'm not going to disagree with this either. However, my interpretation of this phenomenon is a "structural" one, which I explain here (see also here).

(5) Yet in spite of all these, the Federal Reserve believes that the U.S. economy is now close enough to its productive potential that unless some more things go wrong it is no longer appropriate for it to be buying assets and it will be appropriate for it in a year to start raising interest rates even though inflation is still below its 2%/year target.

Well, I'm not speaking for the Fed here (and remember, there are divergent views within the FOMC), but the consensus view seems to be that inflation is just "temporarily" below target. And the recent FOMC statement makes clear that any rate hike will be made contingent on the incoming data. Moreover, even if a rate hike is in the making, it is likely (in my view) to be described as progressing at a "measured pace," similar to the way it was in 2004.

The only way to square (1) through (4) with (5) is if the Greater Crash of 2008-2009 and the still-ongoing Lesser Depression really have pushed between 2 and 4%-age points of our 25 to 54-year-olds out of the labor force permanently, so that we can never get them back, or at least never get them back without an economy at such high pressure to produce inflation that the Federal Reserve regards as unacceptable.

Yes, I suppose this is just another way of saying that a major component of the decline in the E-P rates reported above are attributable to "structural" factors that are better dealt with (if at all) with fiscal policy.

This may be true.But it does raise two questions:

[1] What has made the Federal Reserve so confident that it is true that it is willing to make policy based on it–especially as current inflation is still below the 2%/year target?

Again, I am not speaking for the Fed here. But one argument I often hear is that additions to the Fed's balance sheet have not been very effective, especially in terms of improving the labor market. At the same time, people have expressed some degree of nervousness over "not knowing what they don't know" about operating with such a large balance sheet. The Fed is charting new territory here. The benefits seem small at best, and the risks are not fully known. There is some concern that a low-rate policy may induce a "reaching for yield phenomena," leading to financial instability.

Yes, inflation is still below the 2% target, but not that much below. Does a 1.5% inflation rate warrant a policy rate of 25 basis points? Historical Taylor rules evidently suggest that a higher (but still low) policy rate is desirable in the present circumstances. (Note, once again, this is not necessarily my own view.)

[2] If it is true that the missing 2 to 4%-age points of 25 to 54-year-olds now out of the labor force could not be pulled back in without allowing inflation to rise above it’s 2%/year target, isn’t that an argument for raising the 2%/year target rather than accepting the current 77% 25-54 employment to population ratio as the economy’s limit of potential?

No, I don't think raising the long-run inflation target (to say 3% or 4%) will have any measurable long-run impact on the labor market. A significantly higher inflation tax may even discourage employment (the long-run Philips curve may be positively sloped). If there are things that need "fixing" in the labor market six years into the recovery, they are probably better dealt with directly through labor market policies (like improved maternity leave benefits) or fiscal policies (tax cuts, wage/training subsidies, etc.)

Though it's true there is much less of an argument for higher inflation now in the US, shouldn't central banks learn from this past crisis and be preparing for the next crisis which might necessitate a 3% or 4% inflation temporarily to prevent it from being as disastrous and long lasting as the last one?

The truth is that idle excess money has a return of near -100% for the economy. When there are good private investments out there with returns of -4% we should not let cash price these out of the market by having a -2% fiat return. The -2% fiat return is not real. Nothing get's produced to back it. If the central bank continues defending it, it just enables money to be a claim on other people's savings. That is, in order for people be able to claim their idle cash for stuff without prices rising, central banks will have to use high interest rates which makes private forms of savings lose their value.

Keeping inflation too low is setting ourselves up for a transfer of wealth from private investment savers to fiat savers because fiat savers chose a central bank propped up fake -2% investment instead of a real -4% investment.

The Fed can (and has, in my view) use its discount window to handle crisis events. Emergency lending is dependent on the inflation rate.

As for increasing the long-run inflation target to accommodate the possibility that the expected real return to "good" private investments is -4%, well, sure, I know the argument. However, as a policymaker, I think I would be more concerned with fostering a business climate that lead to a much better expected return to private investment, rather than taxing money holders to induce them to invest in negative return projects. No?

Of course you have to do all you can on solving structural problems but in the mean time while they are not solved (and who says there is always a government solution to these problems, we could be having ressource and energy scarcity issue, demographic issues etc.), we should not incentivize people and banks to store excess savings in a -100% return (to the economy) artificial fiat store of value when there is a -4% store of value that could exist if it wasn't priced out.

There is nothing guaranteeing low risk positive real returns on savings are always possible. The law of thermodynamics tells us that things tend to decay unless you input work and energy into them. The 20th century was one of unprecedented technological and demographic growth so low risk, positive real return investments were easy to find. There is no guarantee they will be as easy to find in the future. Fiat money should be designed to work even when we are not in a booming economy. This implies inflation targets that can sometimes be higher.

It's true, they do not mention low policy rates in the abstract. I've changed the link to a speech made by Jeremy Stein, where he explicitly mentions low rates as one factor possibly contributing to financial instability.

Just to be clear, this is not necessarily my own view. I am just trying to describe the types of arguments that are brought to bear on the question of raising policy rates when inflation is still below target.

Agree that the point you're making is about what FOMC members are thinking, not if this "reaching for yield" is really a problem or not, so the Stein speech does back you up.

FWIW, I thought the point that being 50bps under target doesn't really mandate zero policy rates is a good one that I haven't seen made forcefully enough.

Krugman and Delong both made the Sweden comparison when discussing the possibility of a rate rise in the next 6 months or so. It's a completely nonsense equivalence, Sweden if I recall correctly was 200bps under target with a basically stagnating real economy. Hardly what the US faces just now.

I think inflation is sufficiently hard to control that I'd consider 50bps under target to be essentially on target and if we currently sat 50bps over target I'm utterly certain that Krugman and Delong would agree with me.

So, while being on the low side may be a reason not to have raised rates already in December I don't see why getting ready to lift off is anything but sensible.

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